The Grecian Battle and the Attributes of the Prevailing Entity

Recently, the U.S. Tax Court rendered its decision in the battle known as Grecian Magnesite Mining, Indus. & Shipping Co. v. Commissioner, 149 T.C. No. 3 (July 13, 2017). The decision marks a key victory for taxpayers in a nearly 30-year-war against revenue ruling, Rev. Rul. 91-32, 1991-1 C.B. 107, which has been termed “an outlandish hodgepodge of half-baked theories”1 by a Cassandra who predicted that a court would decide against this revenue ruling.

This battle began in 2001 when, Grecian Magnesite Mining (Grecian), a Greek corporation, acquired an interest in Premier, a U.S. limited liability company (which is taxed as a partnership for U.S. purposes). The major dispute in the case was whether gain realized in the redemption of Grecian’s partnership interest should escape U.S. taxation.

In Grecian, the Tax Court looked to the basic principles of partnership tax and determined that under §741 the redemption of a partnership interest is treated as the sale or exchange of a capital asset and therefore any gain or loss recognized by a partner on the redemption of a partnership interest is capital gain or loss. Under basic principles of international tax, gain or loss from the disposition of personal property, such as a partnership interest, is sourced to the residence of the owner.

The Aggregate View. Partnership taxation is governed by subchapter K of the Code, which reflects two different views of partnership taxation: the aggregate view and the entity view. The aggregate approach generally arises from the fact that a partnership is an aggregation of individuals.

The aggregate view applies a look-through analysis to transactions and tax events to determine the tax treatment applicable to the partner. A partner’s share in these tax events of partnership activities is known as the partner’s distributive share.

The Entity View. The entity view reflects the fact that the partnership is itself a distinct legal entity and focuses on the legal rights that a partner has in its interest in the partnership entity. Under §741, gain from the sale of a partnership interest is generally taxed as gain from the sale or exchange of a single capital asset as if the partnership were an entity rather than as if the gain were from the sale of multiple underlying assets of the partnership. Was §741 the Achilles’ heel of an opposite argument by the IRS?

In Grecian, the IRS argued that §741 should only determine the character (capital or ordinary) of the gain Grecian received from the redemption. The IRS argued that the aggregate view of partnership taxation should be employed and Grecian's gain on the redemption of its interest should thus be treated as the sale of multiple separate interests in each asset owned by Premier. The Tax Court rejected the IRS's reading of §741, reasoning that §741 is a general rule and the exception in §897(g) only reinforces the court's finding that the entity view should prevail.

Attribution of Gain. The IRS argued, a la Rev. Rul. 91-32, that Grecian’s gain from the sale of its partnership interest should be attributable to Premier’s office in the United States. The Tax Court determined that under an exception the IRS cited, gain is attributable to a U.S. office only if the business satisfies a two-pronged material factor test that requires that the U.S. office: (1) be a “material factor” in the production of the income; and (2) “regularly carry on activities” of the type from which such gain is derived.

The Tax Court attacked the IRS’s contention that Grecian’s redemption of its partnership interest in Premier was tantamount to Premier selling its assets and distributing to each partner its pro rata share, this would require abandoning the language of §741. Further, the Tax Court held that Grecian’s gain on redemption was not realized from Premier’s business of mining magnesite, but from the distinct disposition of its partnership interest. Finally, the Tax Court decided that Premier’s office was in the business of selling and producing magnesite, not buying and selling partnership interests.

The Prevailing Entity. With the entity theory prevailing in this case, the aggregate of foreign businesses investing or thinking about investing in U.S. partnerships win. The IRS was overreaching in Rev. Rul. 91-32. However, the war against Rev. Rul. 91-32 is not over because questions remain.

In any hypothetical sale of partnership assets, the assets of the partnership would have been still available to be sold by Premier at a later date with any gain still there and no stepped up basis for the other partners. What if new foreign partners arrived next year? Would they get a stepped up basis for the gain Grecian would have already recognized?

Is §741 the quintessential case for the application of the entity theory of partnership tax law? How many taxpayers actually followed Rev. Rul. 91-32? Are transactions using blocker structures to invest in U.S. partnerships still as useful? Will the IRS appeal the decision or decide not to acquiesce in the holding of the case?

[1] Kimberly S. Blanchard, Rev. Rul. 91-32: Extrastatutory Attribution of Partnership Activities to Partners, Tax Notes, (Sep. 8, 1997).