Are Active Business Requirements for Partnerships Changing?

An IRS ruling released in July seems to run counter to partnership requirements laid out in a 1992 Revenue Ruling. If that's the case, will the IRS work out the kinks?

At first glance, an IRS ruling released July 7, seems to contradict an earlier ruling regarding the active business requirement and partnerships. Ironically, the new ruling cites the earlier statement—Revenue Ruling 92-17—which sits at the crux of the possible controversy.

According to Rev. Rul. 92-17, a corporation that directly conducts a five-year active business is also considered a general partner in an “active business” partnership in which, (1) it had owned a 20 percent interest for five years, and for which (2) its officers, throughout that period, had performed “active and substantial” management functions.

So, if the corporation spins-off its active business, is the corporation engaged in the active conduct of a trade or business for tax purposes? At issue here is whether, through its partnership activities, the corporation is—as required by Sec. 355—engaged in the active conduct of a trade or business immediately after the spin-off.

The Rev. Rul. 92-17 begins, somewhat somberly, by declaiming that the fact that a partnership is engaged in an active business does not, by itself, mean that each of its partners is so engaged. The business conducted by the partnership, therefore, is not “attributed” to its partners. Instead, Rev. Rul. 92-17 says, the determination of whether a partner is so engaged must be made with reference to the activities of the partner, as well as the partnership.

Here, those activities were found to be sufficient. For example, a general partner in an active business partnership is, itself, engaged in an active business if such corporate general partner—through its officers and employees—performs active and substantial management functions for the partnership. Those functions include decision-making regarding significant business decisions and participation in the supervision, direction and control of employees of the partnership in operating the partnership’s business.

Thus, it appears that based on Rev. Rul. 92-17, the partner is not regarded as conducting the partnership’s business. Instead, through the active and substantial management function undertaken by its officers and employees, the partner must establish its own active business: the management of another entity’s trade or business. This business, in which the general partner is engaged, must have been actively conducted throughout the five-year period ending on the date of the spin-off. What’s more, the business must not have been acquired—during the five-year period—in a transaction in which a gain or loss was recognized in whole or in part.

However, the latest ruling seems to counter this logic. It appears that IRS LTR 200227016, which cites Rev. Rul. 92-17 with approval, takes a different approach regarding exactly what business the general partner is conducting. The new ruling describes a corporation that effected a split-off to resolve disputes that cropped up among its shareholders. Specifically, a single business was “vertically” divided. Immediately after the separation, and as part of the plan, the spun-off corporation transferred its business assets (Business A) to an LLC (treated as a partnership). The ruling concludes, nonetheless, that the spun-off corporation will be engaged in the active conduct of Business A.

Furthermore, the ruling says that the active conduct (of Business A) will be maintained regardless of whether the corporation operates the business (Business A) directly or in partnership form as the general partner of the LLC. The ruling, therefore, seems to suggest a somewhat contrary conclusion to the one reached in Rev. Rul. 92-17: That a general partner of a partnership is operating the business conducted by the partnership.

Accordingly, such general partner’s active conduct is not a function of its role as a provider of active and substantial management functions, but instead—under an “aggregate” theory of partnerships—such general partner is deemed to be conducting the activities actually conducted by the partnership.

Has the IRS changed its views regarding the active business requirement where a partnership is involved? If so, does this new approach—in which the activities of the partnership are attributed to the partners, or at least to a general partner—make it easier to satisfy, in these instances, the active business requirement? These questions await further clarification.

Indeed, we hesitate to read too much into this ruling, yet the language used strongly suggests that the Service may be re-thinking its approach to the active business question—where a partnership is involved. And this new approach will, we believe, in most cases, facilitate the ability to meet the active business requirement.

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