Tax Court invalidates long-standing IRS ruling on taxing foreign partners
In July, the U.S. Tax Court rejected a long-standing Internal Revenue Service ruling and held that when a non-U.S. person sells an interest in a partnership or is completely redeemed from a partnership that is engaged in a trade or business in the United States, the non-U.S. seller is, in general, not subject to U.S. federal income tax on the gain from the sale (Grecian Magnesite Mining, Industrial and Shipping Co., SA v. Commissioner, 149 T.C. No. 3)
“This decision has major implications for non-U.S. persons who invest in the United States,” said tax attorney Seth Entin, a shareholder at Greenberg Traurig, who urged CPAs to take note and advise their foreign clients of the implications.
In 2001 Grecian Magnesite Mining, Industrial & Shipping Co. SA, a foreign corporation, purchased an interest in Premier Chemicals LLC, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. From 2001 to 2008, income was allocated to Grecian from Premier, and Grecian paid income tax in the United States. In 2008 Grecian’s interest was redeemed by Premier, and Grecian received two liquidating payments, one in July 2008 and the second in January 2009, but the second was deemed to have been made on Dec. 31, 2008. Grecian realized gain totaling over $6.2 million, of which $2.2 million was attributable to U.S. real property interests and which, at the time of the trial, Grecian conceded is taxable income.
The IRS issued a notice of deficiency for 2008 and 2009, determining that Grecian must recognize its gain on the redemption of its partnership interest as U.S.-source income that was effectively connected with a U.S. trade or business, under Rev. Rul. 91-32.
The Tax Court held that Grecian’s disputed gain of $4.2 million was capital gain that was not U.S.-source income and was not effectively connected with a U.S. trade or business, and therefore Grecian is not liable for U.S. income tax on the disputed gain. The Tax Court said that it would not follow Rev. Rul. 91-32. And as for the conceded liability for gain on the real estate, GMM is not liable for the accuracy-related penalty under Code Section 6662(a) or the failure to file or pay penalty under Section 6651(a) because it reasonably relied on the erroneous advice of its CPA.
“This is a major development,” said Entin. “It basically holds that, contrary to IRS Revenue Ruling 91-32, a foreign investor in a U.S. partnership or LLC can exit free of U.S. tax except to the extent of real estate owned by the entity.”
“These businesses typically appreciate a lot,” said Entin. “For instance, if a foreign investor invests in a tech business, they’ll frequently have significant gain on the sale of their interests. But a tech business may not have a lot of real estate, so the investor can exit nearly tax free.”
“Over the years, a lot of people questioned the reasoning of the revenue ruling, but the IRS pushed forward. They litigated it and they lost, so this is a major victory for foreign investors in the U.S.,” he said.
The IRS took the aggregate rather than the entity approach, according to Entin. “They would like to think that if you sell an interest in a partnership, you’re selling the underlying assets [and therefore any gain is U.S.-sourced]. The court analyzed this and said that the reasoning of Rev. Rul. 91-32, which it criticized as ‘cursory in the extreme’ and ‘lacking in the power to persuade,’ is incorrect.”
“A revenue ruling is not binding law – it’s the litigating position of the IRS,” advised Entin. “The litigating position does, in many cases, lose. Before this case, people worried about the revenue ruling, and it had a ‘chill factor.’ Now we don’t have this chill factor, because the ruling was overruled.”
What happens now? There are a number of possibilities, observed Entin.
The IRS could appeal the case, or issue a non-acquiescence and contest later returns that rely on the case, he noted. Moreover, Congress could decide to override the case via the legislative process. “How non-friendly would they want to be toward foreign investors? With all these caveats, it’s still a major decision,” he said.
“[Tax professionals] should consider advising foreign clients who might invest in a U.S. business to consider making the investment through a non-U.S. entity, rather than through a U.S. corporation, which would be subject to tax on all its income,” he said. “Those with existing investments should take the decision into consideration with respect to restructuring the investments. And those who paid tax in compliance with Rev. Rul. 91-32 should consider filing refund claims. The statute of limitations runs three years from the date of the tax return or two years from the date paid, whichever is later,” he said.
“Of course, if you apply for a refund and the IRS denies it, you have to sue in District Court, so it could go back to more litigation,” Entin said.