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Interest Expense No Longer Characterized As Investment Interest

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Interest Expense No Longer Characterized As Investment Interest

The Tax Court, in the case of William C. Lipnick v. Commissioner, No. 1262-18, 153 T.C. No. 1 (2019), addressed the treatment of interest expense that was initially related to a debt-financed distribution. William Lipnick, the taypayer in the case, received interests in a partnership by gift and bequest from his father in 2013. Prior to that, in 2009 and 2012, the taxpayer’s father had received debt-financed distributions from the Partnership. Debt-financed distributions arise when a partnership borrows money and then distributes the money to its partners. The interest on debt-financed distributions is not treated as partnership interest and generally not deductible at the partnership level. While regulations under IRC Section 163 had been reserved, in Notices issued in 1988 and 1989, the IRS discusses the treatment of interest on debt-financed distributions and generally require the partnership to separately state the interest expense to the partners receiving the distributions. At that point, the treatment of any interest expense depends on tracing the disposition of the funds by the partner and may be characterized in a variety of ways, some of which may yield the interest deductible and some may not. In the Lipnick case, the taxpayer’s father had invested the borrowed funds and so the interest expense that was specially allocated to him from the partnership was treated as investment interest expense.  A taxpayer’s Investment interest expense is deductible to the extent of his investment income.

The issue in the Lipnick case was the treatment of the interest expense to William Lipnick after receiving the transfer of the partnership interests from his father. The position of the IRS was that the characterization of the interest expense remains the same and that the taxpayer essentially stepped in the shoes of his father. In other words, the interest expense would still be separately stated and treated as investment interest expense to the taxpayer. The Tax Court, relying in part on one of the Notices mentioned above, IRS Notice 89-35, and temporary regulations under Section 163 regarding the tracing of interest expenses, disagreed. The Court noted that the taxpayer in this case did not receive the proceeds from partnership loans and did not use the proceeds to acquire property held for investment, or acquire any property for that matter. Therefore, the pass-through interest expense could not be investment interest to him. In fact, the Court held that the interest expense was not related to a debt-financed distribution as to the taxpayer.

The Court found that when the taxpayer acquired the partnership interests from his father “he was in the same position as any other person who had acquired partnership interests encumbered by debt.” Thus, the interest could be treated as interest incurred to acquire the partnership interest. Such interest can be claimed as an interest expense related to the partnership and is usually reported as a separate line on Schedule E to be netted against any net income or net loss reported to the taxpayer by the partnership. The Court also found that it did not matter that the taxpayer acquired the interest from his father (a related party) and that it should not be treated any differently from the case where a taxpayer purchased an interest in such partnership from a third party.

This is an important case for partnerships that have separately stated interest relating to debt-financed distributions. When the partnership interests of the partners who have received distributions are either redeemed, sold, or otherwise transferred, such interest expense will no longer be treated as debt-financed interest expense, but interest expense related to the transfer of the partnership interest.

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