Advisories June 3, 2019

Federal Tax Advisory: A New Theory of Code Definitions

Executive Summary
Minute Read

What does “manifestly incompatible” mean? Our Federal Tax Group parses an IRS Chief Counsel Advice that features a disturbing interpretation of Section 7701’s definitions that taxpayers should beware of—or possibly use to their benefit.

  • Applying the abuse of entity regulation
  • Discriminating against taxpayers singled out
  • Statutory construction that doesn’t otherwise provide
CCA 201917007 concludes that a U.S. partnership is either a foreign partnership or an aggregate of its partners for purposes of taxing the deemed Section 367(d) royalty contributed to it by one of its partners.

Its unusual facts, which were no doubt planned into for purposes of tax reduction, will not be encountered by many other taxpayers in the normal course of business. But its reasoning could be brought to bear on a wide variety of more common transactions—in ways harmful to taxpayers.

The CCA applied the abuse of entity regulation and a special interpretation of Section 7701(a) definitions. The former is not so unusual: the IRS has been asserting the power to treat partnerships as aggregates for many years, but not always with success. And even though it has been backed up by regulatory authority for 25 years, no court has confirmed that authority in those 25 years. This CCA could be the test case.

One of the many problems with the IRS treating a partnership as an aggregate on audit in the case of a single taxpayer is that all other similarly situated taxpayers are likely to enjoy entity treatment. By choosing to use audit rather than published guidance to apply aggregate treatment, the IRS inevitably will discriminate against taxpayers singled out. Some taxpayer will argue that is wrong; maybe this one.

But the CCA’s interpretation of Section 7701(a) is even more disturbing. It focuses on the introductory sentence that says the definitions in that subsection apply except as “manifestly incompatible” with other provisions of the Code. It found that treating the partners as domestic was manifestly incompatible with Section 367(d). However, Section 7701(a)(4) says that a domestic partnership will be treated as domestic unless otherwise provided in regulations; and there is a regulation, but it does not otherwise provide.

The CCA reasons that because the introductory sentence appears first in Section 7701, it supersedes the “except as otherwise provided” language. It also strongly implies that in every case that a taxpayer or the IRS applies the definitions, it must first run the manifestly incompatible analysis.

If so, that is a new approach never before applied to Section 7701. Taxpayers should beware, but also be prepared to use it to their benefit.

For more information, please contact Jack Cummings at 919.862.2302.
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