IRS Drubbed In Tax Court On Partnership Interest Deductions

IRS Drubbed In Tax Court On Partnership Interest Deductions

Whether and how and when you can deduct interest is largely based on how the money you borrowed was spent. The tracing rulings that follow the borrowed proceeds are pretty challenging. Most of us just try to do the best we can.

Partnerships Are Different

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Then there are partnerships that borrow money. They follow the same rules unless they use the borrowed money to make a distribution to partners. Then it gets really simple for the partnership. The partnership discloses the interest expense to the partners and tells them to figure it out based on what they did with the proceeds.

Generally, the one thing that the partner can’t do is deduct the interest against the income from the partnership, since that is not where the borrowed money went. I suspect a lot of preparers end up doing that anyway because it seems reasonable if you don’t think about it much. Judge Lauber’s recent decision in the case of William Lipnick, identified the circumstance in which deducting the interest from a debt-financed distribution against the partnership income actually is the right answer. It’s a regular decision making it something of a big deal, so pay attention.

Pretty High Stakes

The stakes were pretty high – over $700,000 including accuracy penalties. And it was a pretty simple issue. There were three partnerships Mar-cal, Mayfair and Brinkley that flowed interest expense to Lipnick. The interest at the partnership level traced to debt-financed distributions. Nonetheless, Lipnick deducted the interest against the partnership income (which was higher than the interest deductions).

The IRS position was that the interest should have been treated as investment interest, limited to investment income and reportable as an itemized deduction. What made the difference?

Why This Situation Is Different

As it turned out, William Lipnick never received any of those debt-financed distributions. The distributions had gone to his father Maurice Lipnick, who had transferred some of the interests to Willam during his lifetime with the balance passing after his death in 2013.

This made William’s relationship to the partnership debt different than his fathers. To William, the debt was part of his acquisition basis in the partnership. For Maurice the debt traced to however he happened to spend the money – likely making it investment interest. For William, the debt traces to his acquisition of the partnership interest making it deductible against the partnership income allocations……Read More>>

 

Source:- forbes

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