Top Tax Cases Of 2024, Part 1: Partnerships

Introduction to 2024’s Top Tax Cases: A Partnership Focus

In this episode of Tax Notes Talk, Damien Martin and Tony Nitti, tax partners at EY, dive into their top tax cases of 2024, focusing on two significant partnership cases: Denham Capital Management LP v. Commissioner and Surk LLC v. Commissioner. The discussion is part of a three-part series, offering insights into the practical implications of these cases for taxpayers and practitioners alike. Damien and Tony_sidestep some of the more widely discussed Supreme Court rulings, such as Moore and Loper Bright Enterprises, to focus on cases with more immediate relevance to those dealing with partnerships and self-employment taxes. The podcast begins with some lighthearted banter about why the annual series skipped a year, but quickly gets into the meat of the matter, addressing rumors and conspiracy theories about Damien’s supposed "diva-like demands." Damien humorously deflects these rumors, revealing that he was sidelined by a serious medical issue in late 2023, but has since recovered and is back to discussing tax cases with his signature enthusiasm.

Case 1: Denham Capital Management LP v. Commissioner – A New Era for Limited Partners

The first case discussed is Denham Capital Management LP v. Commissioner (TC Memo 2024-114), a decision that has sent shockwaves through the partnership tax community. At its core, the case addresses the thorny issue of whether a state-law limited partner should be treated as a "passive investor" for purposes of self-employment tax under Section 1402(a)(13). The Tax Court ultimately ruled against the taxpayer, finding that the limited partners in question were far too active in the partnership’s operations to qualify for the exception.

Tony Nitti lays out the background, explaining that the case builds on the 2011 Renkemeyer decision, which established the "passive investor standard." In Renkemeyer, the court determined that a partner’s involvement in the partnership’s business activities could negate their ability to claim the Section 1402(a)(13) exception. Soroban (a 2023 case) further complicated things by expanding this principle to state-law limited partnerships, leaving open the question of how to practically apply the functional analysis required to determine whether a limited partner is truly "passive."

The Denham case fills this gap. The facts are striking: Denham Capital Management LP, a limited partnership, had five limited partners who were deeply involved in the partnership’s operations. They were required to devote "substantially all" of their time to the partnership, served on key committees, and were integral to the partnership’s investor relations and decision-making processes. The IRS argued that these activities went far beyond what a passive investor would reasonably undertake, and the Tax Court agreed. Using a functional analysis, the court determined that the limited partners were effectively acting as general partners, making them liable for self-employment tax on their distributive shares of income.

Damien notes that this decision is a significant shift for asset managers and private equity firms, many of whom have structures similar to Denham’s. While the ruling creates uncertainty, it also highlights the importance of carefully reviewing partnership agreements and Fact patterns to ensure compliance with the IRS’s evolving standards.

Case 2: Surk LLC v. Commissioner – Basis Adjustments and the Limits of Loss Deductions

The second case discussed is Surk LLC v. Commissioner (TC Memo 2024-99), which deals with the complexities of basis adjustments and loss limitations under Section 704(d). Tony Nitti describes this case as a "technical, but important" ruling that reinforces the consequences of improper basis tracking and loss deductions.

The facts of the case are straightforward: Surk, a partner in a partnership, deducted $3.3 million in losses in excess of its basis during the 2014 and 2015 tax years. While the IRS ultimately caught this error, the statute of limitations for those years had already expired. The IRS attempted to address the issue by reducing Surk’s basis in the partnership in a later year (2017) when its basis had increased due to positive adjustments. Surk argued that the IRS could not retroactively adjust its basis for closed tax years, but the Tax Court sided with the IRS, finding that the adjustments were necessary to prevent an abusive result.

The court’s interpretation of the ordering rules for basis adjustments under Section 705 and the related regulations (1.704-1(d)(2)) was key to this decision. The ruling clarifies that previously allowed losses must be taken into account before suspending losses from prior years. This ensures that taxpayers cannot exploit the system by claiming excess losses in one year and then benefiting from inflated basis in later years.

Damien highlights the practical implications of this case, noting that it underscores the importance of accurately tracking partnership basis and ensuring compliance with loss limitation rules. The decision also serves as a reminder that the IRS is willing to use creative arguments to address abusive or noncompliant behavior, even if it means reaching into subsequent years.

Implications and Takeaways: A New Landscape for Partnerships

The discussion of these two cases highlights the ongoing challenges and uncertainties in partnership tax law. For Denham, the key takeaway is that limited partners who are actively involved in the business may no longer rely on their state-law status to avoid self-employment tax. Damien and Tony emphasize the need for a "functional analysis" to determine whether a partner’s activities cross the line into what is effectively a general partner role. This requires a nuanced understanding of the facts and circumstances, as well as the evolving standards set by the courts.

For Surk, the decision drives home the importance of proper basis tracking and compliance with loss limitation rules. The IRS’s willingness to adjust basis in later years to address prior-year abuses serves as a cautionary tale for taxpayers and practitioners alike. The ruling also underscores the complexity of the partnership tax rules and the need for careful planning to ensure compliance.

Both cases remind us that partnership tax law is a dynamic and evolving field, with ongoing disputes between taxpayers and the IRS over the interpretation of ambiguous statutes and regulations. As Damien and Tony note, these disputes often require a combination of technical expertise and practical judgment to navigate effectively.

Conclusion: Navigating the Uncertainty

The discussion concludes with a broader reflection on the state of tax law and the challenges it presents for practitioners. Damien and Tony acknowledge the uncertainty created by cases like Denham and Surk, but they also see opportunities for taxpayers to proactively address these issues. For instance, in the wake of Denham, partnerships may need to revisit their structures and agreements to better align with the IRS’s functional analysis. Similarly, the Surk decision highlights the importance of robust basis tracking and compliance processes.

While the possibility of legislative or regulatory clarity in the future is raised, Damien and Tony are pragmatic about the likelihood of such changes. In the meantime, taxpayers and practitioners must continue to navigate the complexities of the current landscape, relying on careful analysis, sound judgment, and a deep understanding of the evolving case law.

Final Thoughts: The Ever-Changing Landscape of Tax Law

The podcast wraps up with a nod to the ever-changing nature of tax law and the importance of staying informed. Damien and Tony encourage listeners to tune in for the next installments of the series, where they will discuss additional cases involving S corporations and C corporations. As they sign off, they leave listeners with a renewed appreciation for the complexity and nuance of tax law—and perhaps a few laughs at the expense of Damien’s imagined "diva-like demands." For those who work in or around partnerships, these cases are a must-know, offering valuable insights into the practical implications of the latest legal developments. Stay tuned for parts two and three of the series!