Question

Can you provide an example of the Aggregate Approach? How is it different from the Entity Approach?

Answer 1

Entity versus Aggregate Theories of Partnership Taxation

Following is an excerpt from an article, Section 1374 and the S Corporation Partner, by Nellen and Karlinsky, published in the Fall 1992 Journal of S Corporation Taxation. The article provides some examples of where both the entity and aggregate theories are applied.

Entity and Aggregate Approaches

The rules governing the federal taxation of partnerships and partners follow two distinct approaches – aggregate and entity. The aggregate (conduit) approach views a partnership as though each partner owned the assets and liabilities of the partnership. An entity approach treats the partnership and its partners as separate entities. The existence of these two vastly different approaches often leads to confusion when there is no specific statutory language offering guidance. Congress is well aware of the confusion, but seldom provides language to avoid it, presumably on the assumption that which theory applies depends on which is most appropriate for the particular section involved. The aggregate theory is often used to ensure that income is correctly characterized as capital or ordinary, and to allow limitations such as Section 267 (related party loss disallowance) and Section 170 (charitable contribution limitation) to be applied, while the entity approach is often applied in the interests of administrative simplicity and to ensure that certain rules are not abused.

The aggregate approach

Section 701 provides that the owners are subject to tax, not the partnership. Also, Section 702 lists items that must be separately reported to the partners so that they may apply certain limitations to them. For example, capital losses and charitable contribution limitations are applied at the partner level, not at the partnership level. However, items not requiring the application of special limitations, such as the sale of inventory in the ordinary course of the partnership’s business would be reported to the partner as part of the operating income or loss.

A few partnership rules treat the partners as if they owned proportionate shares of each partnership asset. For example, Section 751 requires a selling partner to treat disposition gain or loss as ordinary, not as capital, to the extent it represent gain or loss attributable to the ordinary assets of the partnership, such as inventory and unrealized receivables. Thus, a partner cannot treat his partnership interest as separate from the assets of the partnership when he disposes of his partnership interest. The IRS has extended this approach to a partner’s disposition of his partnership interest through use of an installment note. The IRS, relying on the purpose of Section 751 and the aggregate view that a partner should be treated no differently than an individual selling a business, has held that to the extent the partner’s interest represents property for which the installment sales method is not available, the partner may not use that method.

It is interesting to note that though the law requires a partner selling its interest to consider whether any of the amount realized is attributable to ordinary income assets of the partnership under Section 751 (“hot assets”), there is no corresponding provision to ensure that the selling partner would be given this information by the partnership. Section 6050K and the regulations requires a partnership to file Form 8308 if there is a sale or exchange of a partnership interest and any consideration received by the partner is attributable to “hot assets” of the partnership. However, the Form 8308 does not require any dollar amounts to be reported. In addition, the partner will not know for sure whether hot assets exist because regulation Section 1.6050K-1(a)(1) and the instructions for Form 8308 state that if a partnership is in doubt as to whether any of its property constitutes Section 751(a) assets, they may file the form anyway to avoid penalties. Thus, if the selling partner wants to be in compliance with Section 751(a), it will have to rely on the partnership’s willingness to provide such information without any statutory compulsion on the partnership to do so.

Another provision which treats a partner as owning partnership property is the related party loss disallowance rules of Section 267(a). Regulation Section 1.267(b)-1(b) provides that in determining if Section 267 applies to a partnership transaction, each partner is considered as having entered into the transaction with the person who dealt directly with the partnership. Thus, if the partnership sells land to partner Y’s brother at a loss, Y will not be able to deduct his share of that loss under Section 267. This regulation provides no guidance on how the partnership is to report the information on the transaction to the affected partner.

Similarly, the Section 469 passive activity regulations require an aggregate approach to classify a partner’s gain or loss from disposition of all or part of his partnership interest as passive or non-passive activity. Regulation Section 1.469-2T(e)(3) requires a partner to separate his gain or loss into passive activity and non-passive activity components, based on what the gain or loss would be if the partnership had sold each of its activities, including any investments it owns. The regulations do no specifically require the partnership to provide this information to the partners and there is no line provided on the Form K-1 for it. Thus, it is unclear how a partner is to obtain such information.

The entity approach

The IRS has stated the generally, subchapter K follows an entity approach with respect to partnership interest transactions. Example of the entity approach include Section 705 which requires partners to track basis in their partnership interests (outside basis), separate from their proportionate share of the partnership’s basis in its assets (inside basis). Section 707 recognizes that certain transactions such as the sale of property between a partner and a partnership are to be treated as if the parties were completely separate entities.

The IRS has taken the entity approach to solving partnership questions involving the interplay of subchapter K and rules outside of subchapter K. In Revenue Ruling 57-154 the IRS held that a taxpayer could not defer gain under the involuntary conversion rules of Section 1033 by buying an interest in a partnership which owned property similar in service or use to the property converted. Thus, the IRS followed an entity approach by implying that the partnership interest is not viewed as proportionate ownership by the partner of each partnership asset. Similarly, under Section 1031, partnership interests are not considered like-kind even if each partnership’s underlying properties would be like-kind.

Similarly, in Revenue Ruling 75-62 and related GCM 36074, the IRS followed an entity approach in holding that a life insurance company should consider its investment in a partnership as an “other asset” under Section 805(b)(4)(B), rather than ownership of a proportionate share of each partnership asset. In the Revenue Ruling, the IRS stated, “there is no indication in the legislative history of section 805(b)(4)(B) of the Code suggesting that the adoption of the entity approach under the facts of the instant case is inappropriate, and in the absence of tax avoidance, there is not compelling reason to view the taxpayer’s interest in the aggregate.”

In its GCM, the IRS concluded that if it is not possible to tell from the legislative history, as to whether an aggregate or entity approach would best fit with the purpose of the rule, it is “appropriate to consider questions of administrative convenience.”

A further example of applying the administrative convenience criteria are the proposed Section 179 regulations. Proposed regulation Section 1.179-2(b)(3) and (4) provides that a partner of S Corp. shareholder need not consider his share of the entity property placed in service during the year in determining if the partner or shareholder individually placed over $200,000 of Section 179 property in service. The preamble to these regulations states that this rule was provided for administrative convenience.

Petroleum Corporation of Texas, Inc. and Subsidiaries v US (Petro) (as well as Holiday Village Shopping Center v. US) involved the application of the depreciation recapture rules when a corporation distributed an interest in a partnership to its shareholders in liquidation of the corporation. The taxpayers took the position that the recapture provisions did not apply since those provisions do not state that distribution of and interest in a partnership would trigger its application. Both courts in the Holiday case, as well as the District Court in Petro, took the contrary position. They held that depreciation recapture was required as if the corporation had distributed the partnership’s assets to the shareholders, not that they had distributed a single asset, namely the partnership interest itself. The Fifth Circuit did not extend the statutory meaning to say that the partnership interest should be treated as consisting of ownership in each of the partnership’s assets (an aggregate approach to Section 1245), in order to classify partner gain as capital or ordinary.

Thus, we have the Fifth Circuit in Petro taking the statutory language alone to get to an entity-based solution. In contrast, the lower court in Petrol and the courts in Holiday went beyond the written words to determine that that aggregate approach is most consistent with Congressional intent with respect to the particular IRC provision at issue. They found that the purposed of the recapture provision was to tax at ordinary income rates, that taxpayer who benefited from the depreciation deductions. These courts held that since the corporate partner benefited from the depreciation deductions passed through from the partnership, it should be the one to recapture the ordinary income upon sale of the asset by the way of a liquidating distribution to its shareholders, it is considered to have disposed of its share of the partnership assets with the depreciation recapture provisions applicable as they would be for any straight asset disposition.

A strict statutory language approach was also followed by the Tax Court in E.J. Frankel v Comm’r. In that case, two individuals owned identical interests in a partnership and an S corporation. The partnership loaned money to the S corporation and each individual included the debt in his basis and deducted S corporation loss against it. The Court reviewed the applicable statutory language which clearly stated that the indebtedness must run directly to the shareholder in order to be included in basis. The Court also thought it would not be correct to ignore the partnership. Entity versus aggregate theories were only discussed in a footnote, as the Court looked strictly at the statutory language to reach its conclusion that the partnership loan to the S corporation could not be treated as a loan made by each partner. Thus, an entity approach was followed.