APPLYING SUBSTANTIAL ECONOMIC EFFECT RULES WITH PASS-THROUGH PARTNERS

Under Code §704(b), allocations of partnership items of income, gain, loss, deduction and credits must have "substantial economic effect" to be respected for federal income tax purposes. The economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Further, the allocations cannot be "transitory" or "shifting."

In testing for substantial economic effect, issues arise how to apply the tests if a partner is a pass-through entity for income tax purposes. Proposed regulations issued in 2005 relating to examining the tax effects on the ultimate owners of pass-through partners were recently finalized.

Generally, the regulations require that the tax consequences are examined at the owner level of the pass-through entity (or the beneficiary level, for trusts and estates). Pass-through entities for these purposes include partnerships, S corporations, estates, trusts, and qualified Subchapter S subsidiaries. Treas.Regs. §1.704-1(d).

Look through treatment will also apply for controlled foreign corporations (CFCs) also, but only if U.S. shareholders of the CFC own in the aggregate (directly or indirectly) at least 10% of the capital or profits of the partnership. If the look-through rules apply, the U.S. shareholders are the ones examined, as to income that passes through or would pass through under Code §951(a). Treas.Regs. §1.704-1(d)(3).

T.D. 9398, 05/16/2008; Reg. § 1.704-1

WAIVER OF DIVIDENDS

Generally, a taxpayer entitled to income cannot simply say "don't pay me" and avoid being taxed on the income. In that situation, under the doctrine of constructive receipt the taxpayer will have to report the income, and then further account for the disposition of the income that they should have received - for example, such forfeited income could be treated as a gift.

A recent private letter ruling illustrates an exception to this rule that is not widely known or applied. This relates to the waiver of corporate dividends.

In the ruling, a corporation desired to increase its dividends to its public shareholders. However, if it had to pay the increased dividends to the nonpublic shareholders, then there would not be enough cash available to bring the dividend to the desired level for the public shareholders. The other shareholders agreed to waive the payment to them of the dividend to the extent it exceeds the current dividend level. A private letter ruling was sought that the waiving shareholders would not have to report the unpaid dividend income under the constructive receipt doctrine.

Going back to 1953, the IRS has provided guidance to the effect that a waiver of dividends by a majority shareholder would be respected if the resulting increased dividend to minority shareholders was not payable to shareholders who had a direct family or business relationship with the waiving shareholder, and a valid business purpose existed for the waiver. In Rev.Proc. 67-14, 1967-1 CB 591, the IRS listed four "safe harbor" criteria that must be met before the IRS will issue a favorable ruling on a dividend waiver. The criteria are:

(1) A bona fide business reason must exist for the waiver;

(2) The relatives (e.g., brothers, sisters, spouse, ancestors, and lineal descendants) of the waiving shareholder must not be in a position to receive more than 20% of the total dividends distributed to the nonwaiving shareholders;

(3) The ruling is not effective if any change in stock ownership (other than death) enables nonwaiving relatives to receive more than 20% of the dividend; and

(4) A ruling issued on a proposed waiver won't be effective for a period longer than three years from the date of the ruling.

The IRS ruled favorably in the private letter ruling. The ruling is helpful by providing examples of business reasons that are sufficient for the IRS. In the ruling, the IRS noted the waiver will enhance the market value of the corporation and will thus will provide it with greater access to capital markets for future equity offerings, and will further permit the corporation to maintain adequate capital to support its operations and expand its business.

PLR 200820019

CHARITABLE DEDUCTION AVAILABLE FOR SPECIAL LICENSE PLATES

While not a big dollar item, the IRS has released a letter it issued to a member of the U.S. House of Representatives regarding the ability of a constituent to deduct amounts paid to the State of Minnesota for a special license plate relating to the conservation of natural habitats. In the letter, the IRS noted that Minnesota charges an extra $30 over the regular license plate fees for such habitat license plates, and that the $30 is used to buy and manage habitats for public uses, such as hiking and hunting.

The letter goes on to conclude that when a taxpayer, with the intention of making a gift, purchases an item from a qualified charity, the excess of the payment made over the value received is a charitable contribution for the excess. Since many states offer special license plates whose fees are dedicated to charitable causes, the extra fees should thus be eligible for income tax charitable contribution deductions.

While the letter does not give any cites to the Internal Revenue Code, the statutory support for this deduction is presumably IRC Section 170(c)(1), which includes as a deductible charitable contribution payments to a state for exclusively public purposes.