The Second Circuit Court of Appeals for a second time reversed the judgment of a district court against the IRS in the long-running Castle Harbour/TIFD III-E case involving the characterization of two foreign banks’ interests in a partnership. The Second Circuit again held that the foreign banks' interests in the partnership were not capital interests and that the partnership income to them should have been allocated to the other partner in the partnership, a U.S. subsidiary of General Electric Capital Corp., resulting in substantial taxes and penalties. For earlier Tax Matters coverage, see “Family Partnership Rules Applied in TIFD III-E Remand” (Jan. 2010, page 60); “IRS Scores Victory Over Alleged Tax Shelter” (April 2007, page 78); and “A Winning Tax Shelter Case” (June 2005, page 93).
In the initial appeal, the Second Circuit remanded the case for consideration of the taxpayer’s additional argument that the banks qualified as partners under Sec. 704(e)(1), related to capital interest in a partnership. The district court then concluded that the foreign banks were owners of a capital interest in a partnership in which capital was a material income-producing factor, and that therefore the partnership income allocations were proper.
On the second appeal, the Second Circuit held that Sec. 704(e)(1) did not apply in this context, since its purpose was to allow recognition of interfamilial transfers (gifts) of partnership interests. The district court’s finding that the banks held a capital interest based on the claimed risks that they might have to bear was at odds with the previous ruling. The Second Circuit concluded that the banks’ interests were not capital interests within the meaning of Sec. 704(e)(1) for the same reasons it had previously concluded that they were not bona fide equity interests.
By Karyn Bybee Friske, CPA, Ph.D., Schaeffer Professor of Business Ethics and professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.
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