Statutory Conflicts, Interpretation Animate Recent IRS Guidance
(For a parallel analysis of these issues in my latest letter to the editor of Tax Notes Federal, see my letter to the editor, here).
I write today about two items of interest. The first item is an ILM (the “Section 741 ILM”) that holds that section 1221 can override section 741, an apparent case of a facial statutory conflict between these two code sections. (See ILM 202309015, 2023 TNTF 43–17, Mar. 3, 2023; Kristen A. Parillo, “Sales of Easement Partnership Interests Produce Ordinary Income, Tax Notes Federal, Mar. 13, 2023, p. 1818; Robert Willens, “Sale of LLC Interests Should Have Led to Capital Gains”, 2023 TNTF 48–18, Mar. 13, 2023).
The second item is an eminently sensible GLAM (the “Section 961 GLAM”) (See AM 2023–002, 2023 TNTF 47–25, Mar. 1, 2023, a legal memorandum to Deborah T. Palacheck, Cross Border Activities, LB &I, from Peter H. Blessing, ACC Int’l) from the tax policy point of view, but which contradicts the plain wording of a validly issued final regulation. As a result, the GLAM may violate the Chief Counsel’s own rules on following final regulations in providing guidance to the field and the public. (See CC-2003–014, 2003 TNT 93–7, May 8, 2003, which generally requires Chief Counsel attorneys to follow final regulations. See, also, Internal Revenue Manual, part 32, chapter 1).
1. The Section 741 ILM
The Section 741 ILM involves a taxpayer in the business of marketing syndicated conservation easements in order to make donations to charity. The strategy involved the holding for sale and then selling various LLC (partnership) interests whereby, if the actual underlying real property had been so marketed and sold, the inventory/held for sale exclusion under section 1221 would apply. The problem for the IRS was that the real property was held in various partnerships and what was sold were partnership interests. As a result, section 741 on its face applied. Neither section 741 or section 1221 makes an exception for the other and, thus, there is a facial conflict between the two code sections on these facts.
The IRS holds in the Section 741 ILM that:
“Congress intended to give capital asset treatment only to the sale of partnership interests that are in fact held as capital assets….Congress’s statement that §741 retained merely the general rule of present law that the sale of a partnership interest is treated as the sale of a capital asset leaves open the possibility for ordinary treatment on the sale of a partnership interest when the facts and circumstances are appropriate.”
Left unstated for public view but likely contained in the blacked out “hazards of litigation” section in the ILM, the Section 741 ILM omits discussing the Pollack Tax Court case (69 T.C. 142 (1977)), where the court, in a reviewed opinion, stated that section 741 was not subject to section 1221. As a result, Pollack did not apply the Corn Products doctrine (since invalidated) to a loss on a sale of a partnership interest because that would involve the application of section 1221 to a transaction governed by section 741. The court held:
“We conclude that Congress intended section 741, if applicable, to provide capital gain or loss treatment on the sale or exchange of a partnership interest by a partner without regard to section 1221. Indeed, Congressional use of the phrase “shall be considered” in section 741 is unambiguous and mandatory on its face.”
I expect that if the Tax Court gets this case, it will rule in favor of the taxpayer given its prior explicit holding on the issue in its reviewed opinion in Pollack. The question will then be what happens elsewhere.
Congress just did not contemplate what to do if section 1221 conflicted with section 741. And so, it is difficult to say how this will turn out in the end. I favor section 741 trumping section 1221 because the Congress in 1954 wanted to simplify the law in this area and just did not realize that, as drafted, section 1221 could interfere with that goal.
2. The Section 961 GLAM
The Section 961 GLAM involves what is called a “mid-year distribution” whereby the distribution occurs before the end of the taxable year. The question at issue was whether the basis increase allowed by section 961(a) for the subpart F inclusion for that year could offset the distribution. The IRS has just answered yes, it can. (See Andrew Velarde, “Basis Adjustment Letter Ruling Portends Good News for Taxpayers”, Tax Notes Federal, Feb. 13, 2023, p.1045 (the “Velarde Section 961 News Story”), describing LTR 202304008, 2023 TNTI 19–21, Jan. 30, 2023. The letter ruling does not contain any legal analysis of the section 961 basis issue-just an unsupported conclusion. See, also, Matthew M. Chen, Ethan A. Hicks, Clayton H. Collins, and Brook E. Hrouda, “Retrocausity and Distributions of Current-Year PTEP”, Tax Notes Int’l, Sept. 28, 2020, at part IIB (the “Chen Article”)).
The pertinent section 961 regulation, reg. §1.961–1(a)(1) (T.D. 6850, Sept. 15, 1965), provides that basis (stock in the foreign corporation or a partnership interest where a partnership owns the foreign corporation stock):
“[S]hall be increased under section 961(a), as of the last day in the taxable year of such corporation on which it is a controlled foreign corporation, by the amount required to be included with respect to such stock or such property in such shareholder’s gross income under section 951(a) for his taxable year in which or with which such taxable year of such corporation ends.”
Example 1 of reg.§1.961–1(c) puts the nail in the coffin. It states:
“Domestic corporation M owns 800 of the 1,000 shares of the one class of stock in controlled foreign corporation R which owns all of the one class of stock in controlled foreign corporation S. Corporations M, R, and S use the calendar year as a taxable year. In 1964, S Corporation has $100,000 of earnings and profits after the payment of $11,250 of foreign income taxes, and $100,000 of subpart F income. Corporation R has no earnings and profits. With respect to S Corporation, M Corporation is required to include in gross income $80,000 (800/1,000 × $100,000) under section 951(a), and $9,000 ($80,000/$100,000 × $11,250) under section 78. On December 31, 1964, M Corporation must increase the basis of each share of its stock in R Corporation by $100 ($80,000/800).”
The statute itself, section 961(a), also seems to say that the basis increase occurs when the inclusion occurs, which is at the end of the tax year of the foreign corporation. This is similar to how section 706(a) works in the case of inclusions by partners of partnership income allocated to them. Section 961(a) states that the basis of the share of stock of the foreign corporation:
“[S]hall be increased by the amount required to be included in ….gross income under section 951(a) with respect to such stock….but only to the extent to which such amount was included in the gross income of such United States shareholder.”
And section 951(a) states in pertinent part that:
“If a foreign corporation is a controlled foreign corporation at any time during any taxable year, every person who is a United States shareholder….of such corporation and who owns…. stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends — his pro rata share….of the corporation’s subpart F income for such year….”
The outside tax basis situation under section 961(a) is parallel in effect as to what happens under section 731(a) when a partnership distribution exceeds outside basis of a distributee partner at that time. First, under reg. §1.705–1(a)(1):
“Section 705….[provides] rules for determining the adjusted basis of a partner’s interest in a partnership. A partner is required to determine the adjusted basis of his interest in a partnership only when necessary for the determination of his tax liability or that of any other person. The determination of the adjusted basis of a partnership interest is ordinarily made as of the end of a partnership taxable year [when the inclusion occurs]”.
Reg. §1.731–1(a)(1)(i) and (ii) then states:
“Where money is distributed by a partnership to a partner, no gain shall be recognized to the partner except to the extent that the amount of money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution….[ but] advances or drawings of money or property against a partner’s distributive share of income shall be treated as current distributions made on the last day of the partnership taxable year with respect to such partner.”
Without this special “drawing or advance” rule, the distribution would be taxable under section 731(a) if it exceeded outside basis of the partner under section 705 at the time of the distribution (See McKee, Nelson & Whitmire, “Federal Taxation of Partnerships & Partners” (WGL), para. 19.03[2] (2007). See, also, Rev. Rul. 92–97, 1992–2 C.B. 124, and Rev. Rul. 94–4, 1994–1 C.B. 195), but the regulations add the special rule for drawings or advances to match the outside basis of the distributee partner to the cash distribution by the partnership. There is no such rule in the pertinent section 961(a) regulation even though the two provisions otherwise operate in parallel.
The language “shall be increased under section 961(a), as of the last day in the taxable year of such corporation on which it is a controlled foreign corporation” seems very clear. How is it possible that that this language, as asserted in the Section 961 GLAM “could be read to conclude that the adjusted basis of USP’s FS stock is computed before or after taking into account the $100x increase under section 961(a)” (Emphasis added)? (See Kuntz, Peroni & Bogdanski, “U.S. International Taxation” (WGL), para. B3.09[2] and [3] (1992), which is consistent with the last day of the year approach although admittedly not discussing so-called mid-year distributions as in the Section 961 GLAM).
Admittedly, the answer in the Section 961 GLAM should be the answer that the current section 961 regulations provide. The Chen Article states in this regard:
“Although the [section 961] regulations do not speak explicitly to this point [the timing of the basis increase as it relates to the distribution], their framework — along with that of the statute and the underlying policy of sections 959 and 961 — supports quantifying section 961(b)(2) gain when the last day of CFC status has been reached, at which point the section 951(a) and GILTI inclusions can be determined and basis is increased under section 961(a)….”
This is what I would call a “relation back” theory of taxation. I do not disagree with the tax policy expressed in the Chen Article. I support it. But the words of the regulation say something else and cannot be explained away by citing tax policy that is not consistent with the words used.
Matching the distribution of previously taxed income to the increased tax basis caused by the subpart F inclusion is very clearly the best economic result and the best tax policy answer. But the IRS is tasked with implementing the statutes that Congress enacts through regulations or other means and once having issued regulations, those regulations should be followed by the IRS when the words used are clear. Tax policy and appropriate economics should only be a factor where the words of the regulation text are ambiguous. This is so even if the wrong tax policy result flows from the words used in the governing text. (This is expressly the situation addressed by SCOTUS in the Gitlitz case, 531 U.S. 206 (2001)).
As has been said more than once, if the words of a statute or a regulation do not support what the best tax policy answer should be, change them. So far, that has not been done.
Once again, the pertinent regulation says that:
“[Basis]….shall be increased…as of the last day in the taxable year of such corporation….by the amount required to be included…in such shareholder’s gross income…for his taxable year in which or with which such taxable year of such corporation ends.”
Why is that at all ambiguous? Is it the right tax policy answer to apply the words as written? (I checked the legislative history to section 961 in 1962 and the final and proposed regulation preambles to reg.§1.961–1 in 1965 and found nothing to indicate one way or the other what either Congress or the IRS meant by the language used). Clearly no. Do the words clearly state that basis increases occur at the end of the year of the foreign corporation? Clearly yes. Example 1 of the section 961 regulation quoted above also says so-the basis increase occurs at the end of the year. If somehow this issue gets to court, as sympathetic as the case is for the taxpayer, the taxpayer could lose if a comparison is made to how the distribution issue is handled under section 731(a) and its governing regulations.
If the IRS really believes that its position in the Section 961 GLAM is the correct legal view, meaning a proper reading and interpretation of the language used in the pertinent section 961 regulations, the proper approach would have been to issue a revenue ruling saying so. But by doing what it has done, non-precedential guidance that cannot as a matter of law be relied upon as authority under section 6662 was issued instead. (I understand that other non-precedential guidance saying the same thing will be issued by the IRS in due course. (See reg. §1.6662–4(d)(3)(iii) (defining what is an authority under those rules)). This is not appropriate or consistent with the proper administration of the tax law in my view.
One closing note. In the Velarde Section 961 News Story (cited earlier), which preceded the issuance of the Section 961 GLAM, Laura Williams, who is stated in the story to be in the Office of Associate Chief Counsel (International), is quoted as saying:
“[W]hile there isn’t much explanation to the ruling, the IRS is also working on further guidance in the form of chief counsel advice or a general legal advice memorandum [it turns out to be the Section 961 GLAM] that it hopes to issue in the spring that would offer more analysis….Hopefully, it gives taxpayers some comfort….You can’t rely on a GLAM, but smart people . . . will hopefully take it and get comfortable.” (Emphasis added).
Apparently, I am not one of those people to whom Ms. Williams refers. Oh well….
